Now, with closing submissions set down for a two-week hearing from March 19, S&P has a dilemma.

To settle or not to settle, that is the question.

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The twelve councils bought a bunch of “Rembrandt” toxic structured-finance products in 2007. They tanked 90 per cent in six months and now the councils are suing investment bank ABN Amro for making the Rembrandts, Local Government Financial Services (LGFS) for selling them and S&P for appending their once-hallowed AAA credit rating.

For S&P, this is the first legal assault in the world to proceed to trial. A retinue of claims has been filed against all the credit rating agencies in the US, yet they are mostly bogged down in procedural issues. So the world is watching closely how they play this one.

In complex corporate litigation like this, the outcome can be a roll of the dice.

Even so, a successful defence seems an outside shot.

Unreasonable rating

Looking at the closing submissions which have now been filed with the Federal Court, the councils contend that S&P failed to exercise reasonable care and had “no reasonable grounds” for its AAA rating on the Rembrandts.

The councils argue that this is supported by the limited historical data relied upon to rate the product. This was a new product, a “CPDO”, even more risky than a CDO and based on an index of derivatives which had only been going for a couple of years.

They also say S&P made a “critical error” when it relied on the advice of investment bank ABN Amro regarding the Rembrandt's historical volatility.

“Nobody from S&P ever checked that figure and it was not supported by any data... The figure became the cornerstone of the rating,” says the submissions.

Further, the agency failed to examine a reasonable range of inputs in their modelling and failed to include crucial assumptions and variables.

“The evidence at trial established that S&P did not conduct any modelling for the Rembrandt 2006-3 Notes, or discuss the results of such modelling at any ratings committee.

“Further, the Rembrandt 2006-3 Notes were assigned AAA ratings “because S&P did not want to reveal to investors the error they had made in assigning a AAA rating to the Rembrandt-2”.

Drubbing

The defendants would deny it with the loftiest indignation but their expert witnesses copped something of a drubbing under cross examination during the ten-week trial.

So the risks of an adverse court judgement in its case against the NSW councils loom large for S&P.

It has not had a loss yet, despite its culpable role in the financial crisis where it appended its AAA ratings to an array of high risk structured finance products.

At the heart of the mess is the ratings agency's conflict of interest. They were paid per rating, the more ratings, the better for the bottom line. During the structured products boom which paved the way for the financial crisis they prospered financially.

In fact, the deal was that the bank wouldn't pay them for the rating until the product had been launched. And so deals, and ratings, were rushed through.

Getting tough

Over the past two years, S&P has tried to restore credibility to its tarnished reputation by getting tough and downgrading the US government and a range of European sovereign credit ratings as well.

Can it afford an adverse judgement Down Under? Would that open the floodgates? Could S&P see the case through, even if it deemed its chances of success were slim?

It may decide to fight it out to the bitter end in appeals and strategic litigation as a warning to any potential adversary that they will get bogged down for years in court, at huge cost, should they try it on.

Already it is clear that the councils themselves, without the backing of a litigation funder IMF, would hardly have been able to prosecute such an action – given circa $6 million in costs and potential adverse costs orders of $15 million.